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Family Law Articles

Illinois Family Law Report
A monthly guide to what’s new and important

Volume XIX, Number 10

Article of the Month
The Allocation of Stock Options Upon Dissolution of Marriage

By Margaret A. Bennett

A divorce practitioner should have a thorough understanding of stock options when representing the non-employee spouse or the employee spouse, who has been issued stock options from his employer during the marriage. Stock options are the right to buy shares of stock at a fixed price over a certain period, pursuant to an exercise schedule which says that until a certain amount of time has elapsed, the options have no value because they cannot be converted into stock. Stock option awards to employees are typically called "grants". The price of an option is usually the fair market value of the stock on the day the option is awarded. An exercisable or vested stock option is one that can be converted into stock. A non-exercisable or non-vested stock is one that cannot be converted into stock. Options expire at a certain date in the future if not exercised. If an employee quits or terminates his employment, he usually has a certain period of time within which to exercise his exercisable stock options and the non-exercisable options would be forfeited. Stock options are not QDRO-able and generally cannot be assigned or transferred.

When an employee exercises a stock option, it is always a taxable event and is subject to Federal income tax, State income tax, FICA and Medicare taxes. The transaction is taxed as income in the year the option is exercised. The gross benefit (sale price minus option price) is subject to taxation just like wages. The employer is required to report the exercise of stock options to the Internal Revenue Service on the employee’s W-2 statement.

If a Court awards the right to exercise a percentage of stock options to a former spouse of an employee when exercisable, the employee would have to fill out a notice of exercise on behalf of the non-employee and the company would honor the request. However, the ex-spouse could not directly request the stock to be exercised. Taxes withheld would be at the employee’s rate and not the former spouse’s tax rate, and the employee would be responsible to pay the taxes.

In re Marriage of Moody, 119 Ill.App.3d 1043, 457 N.E.2d 1023, 1026, 1027 (1st Dist. 1983), the Court held that stock options do not constitute property under Section 503 until such time as they are exercised. The Court stated that under the terms of the stock option agreement, the stock options are non-transferable and thus Respondent was unable to realize any profit from a sale or an assignment of his interest under the agreement. If they expire without ever being exercised, they have no value whatsoever. The trial court was directed to retain jurisdiction over the stock options. Similarly, in the case of In re Marriage of Frederick, 218 Ill.App.3d 533, 578 NE2d 612, 618, 619 (2nd Dist. 1991), there was no evidence of the present value of the stock options and appropriately the trial court did not attempt to value them. Stock options are not considered property pursuant to Section 503 of the IMDMA and have no value until and it they are exercised. However, it is my belief that the Court can and should hear evidence as to the value of exercisable stock options, the tax consequence if exercised and the costs associated with exercising the options.

Likewise, any attempt to characterize the employee’s future right to exercise stock options as income would be improper.

Recently, the Appellate Court affirmed the trial court’s refusal to consider past and speculative future stock options income when determining net income for support purposes. In re Marriage of Keagle, May 31, 1996, Ill.App.2d Dist., No. 2-95-0604, Rule 23. The Court reasoned that their ruling is consistent with the Moody and Frederick cases, and the Court stated "…we do not consider it error for the trial court to refuse to consider it error for the trial court to refuse to consider a speculative future benefit when calculating Christopher’s net monthly income for unallocated maintenance and support purposes." Therefore, the Appellate Court in the Keagle case chose not to consider a speculative future benefit when calculating the employee’s net monthly income for support purposes.

The Moody and Frederick cases clearly characterize the nature of stock options but do not provide the matrimonial practitioner with a clear understanding of how to effectively handle this issue when negotiating a case involving stock options. Although the Courts have held that it is improper to value unexercisable/non-vested options at trial, there is no prohibition against allowing the parties to reach an agreement as to the value, and allow the employee spouse to buy-out the non-employee spouse in a negotiated settlement. This will alleviate the need for post decree litigation, and allow the non-employee spouse to receive an immediate benefit rather than a speculative future benefit which is subject to the uncertainty of the stock market and contingent upon the employee spouse’s continued employment.

However, if no agreement can be reached, the Moody and Frederick cases dictate that the Court retain jurisdiction over the options, which will require the Court to revisit the issue of exercisability, the allocation of the options, not to mention the allocation of the taxes to be paid as a result of the exercise. The Court would also be charged with the determination as to whether to allow one or both of the parties to exercise the stock options and retain the stock or immediately sell the stock to obtain cash.

If the options are converted to stock, one or both of the parties must pay or borrow the funds necessary to purchase the stock and the taxes associated with the transaction. This can be very burdensome when considering that stock options are usually awarded in grants exercisable at different times for a period of years. However, many companies have programs to allow the employee to sell immediately some of the shares being exercised. This alleviates the need for the employee to pay cash to exercise the option. Furthermore, in the Moody case, the Court appears to allow the employee spouse to make the decision alone because the stock options are non-transferable.

Below is the stock option language I have developed which will alleviate many of the post decree problems associated with the exercise of stock options when the Court retains jurisdiction over stock options upon dissolution of marriage. This language allows the non-employee spouse the right to be notified when options are exercisable and to serve notice on the employee spouse of the right to exercise options awarded by the Court pursuant to the terms of the Marital Settlement Agreement. This formula also provides for the withholding of Federal, State, FICA and Medicare taxes, thus alleviating the problem with the employee spouse being held responsible for the taxes associated with the benefit derived by the non-employee spouse’s election to exercise stock options.

The parties agree that they shall divide the right to exercise stock options issued to Respondent as follows:

From Plan/Grant _, the Petitioner will receive the right to exercise _ options, and the Respondent will receive the right to exercise _ options. All of these options must be exercised by (insert expiration date).

From Plan/Grant _, Petitioner will receive the right to exercise _ options, and Respondent will receive the right to exercise _ options. All options from this grant must be exercised by (insert expiration date).

From Plan/Grant_, Petitioner will receive the right to exercise _ options, and Respondent will have the right to exercise _ options. There are currently no options that are exercisable from this Plan/Grant. On (date exercisable, _ options will become exercisable, of which Petitioner will receive the right to exercise _ options, and Respondent will receive the right to exercise _ options. On (date exercisable), an additional _ options will become exercisable, of which Petitioner will receive the right to exercise _options, and Respondent will receive the right to exercise _ options. All options from this grant must be exercised by (insert expiration date).

All options not exercised by the prescribed date, as shown in the last sentence of each paragraph for each grant listed above, will be terminated. Additionally, if Respondent leaves the employment of the Corporation, all stock options will be terminated after a prescribed period of time as determined by the Corporation, and the parties shall have no further right to said options.

Respondent shall notify Petitioner each time of the year of the periods during which he can legally sell stock options**. He will forward to Petitioner copies of all notices, correspondence, etc. relating to the options in which Petitioner has an interest pursuant to the terms of this Judgment. Petitioner shall have the right to request that Respondent exercise the right to request that Respondent exercise her share of the exercisable options any time (but sale of said stock may occur only during periods permitted by the SEC regulations and insider trading regulations**). If Petitioner wishes to exercise the above options awarded to her, Petitioner will receive the net proceeds after payment of all taxes and fees incurred as a result of the said exercise. The parties further agree that any personal Federal, State, FICA and Medicare taxes incurred by Respondent in connection with the exercise of the aforesaid stock options on behalf of the Petitioner will be deducted at Respondent’s then current tax rate, and Petitioner will receive no reimbursement from Respondent for said deductions. The above includes all exercisable and non-exercisable stock options not exercised prior to the date of Judgment.
When working with the non-employee spouse or the employee spouse who has been awarded grants of stock options by his employer, you should request a stock option history from the corporation and carefully evaluate each grant and the price at which each option can be exercised. Carefully evaluate the potential tax consequences of each grant of stock options just as you would evaluate the basis of stocks that were purchased over a period of years.

** Only use if insider trading regulations apply to the Respondent. For the convenience of the reader, the above permits the wife to be the Petitioner and non-employee spouse, and the husband to be the Respondent and the recipient of the stock options.